Threat of takeover makes top managers more prone to cheating

New York: Imposing strict external monitoring measures and threat of takeover can be counterproductive on top-level managers as they are more likely to commit fraud when they find the governance mechanisms too coercive, suggests new research.

This goes against the conventional wisdom that external corporate governance measures, such as a threatened takeover, naturally curb financial fraud by company leaders, said Robert Hoskisson, Professor of Management at Rice University in Houston, Texas.

“When top managers face more stringent external control mechanisms, in the form of activist shareholders, the threat of a takeover or zealous securities analysts, they are actually more likely to engage in financial misbehaviour,” the authors noted.

The scholars studied institutional and regulatory data from 1999 to 2012 of companies in the S&P 1500 index, a stock market index of US stocks made by Standard & Poor’s.

They focused on three kinds of external governance mechanisms – dedicated institutional investors, the threat of corporate takeover and ratings agencies.

In the first mechanism, dedicated institutional investors have access to key data because they hold stock over longer-than-average periods of time and closely watch the senior management’s actions.

Traditional agency theory suggests that under that kind of spotlight, financial fraud by managers should shrink. But the data showed the opposite.

Higher levels of dedicated institutional ownership were linked to higher levels of fraud.

To study the effects of this external pressure, the researchers analysed how financial fraud differed if managers were shielded from this pressure by takeover defence provisions.

Traditional agency theory predicts that fraud should increase when more of these shields are in place. But according to the data, when takeover defences increased, financial fraud dwindled.

The researchers found that the likelihood of financial fraud commission decreased 37 percent when the number of takeover defence provisions increase from zero to one.

Finally, ratings agencies also exert pressure. Securities analysts are privy to troves of information and thus serve as a second pair of eyes on a firm and its performance. Their reviews can send a stock price plummeting or soaring.

According to traditional agency theory, more analyst scrutiny should equal less financial fraud. However, according to the scholars’ findings, higher analyst pressure correlated to higher levels of fraud.